What is Consumption?
Consumption is one of the important concepts in economics. It is extremely important because it helps determine the growth and success of the economy. Consumption is the part of income that is devoted to goods and services to derive mental or physical satisfaction. It refers to the final purchase of goods and services by individuals. It is also often referred to as consumer spending. In other words, consumption is the way of satisfying human wants by using economic resources for the purchase of goods and services. For example, the purchase of food, clothes, vegetables, books etc. to satisfy a human need or want is the consumption in an economic sense.
Consumption, in economics, is the use of goods and services by households. Consumption is distinct from consumption expenditure, which is the purchase of goods and services for use by households. Consumption differs from consumption expenditure primarily because durable goods, such as automobiles, generate an expenditure mainly in the period when they are purchased, but they generate “consumption services” (for example, an automobile provides transportation services) until they are replaced or scrapped. Neoclassical (mainstream) economists generally consider consumption to be the final purpose of economic activity and thus the level of consumption per person is viewed as a central measure of an economy’s productive success.
The study of consumer behavior plays a central role in both macroeconomics and microeconomics. Macroeconomists are interested in aggregate consumption for two distinct reasons. First, aggregate consumption determines aggregate saving, because saving is defined as the portion of income that is not consumed. Because aggregate saving feeds through the financial system to create the national supply of capital, it follows that aggregate consumption and saving behavior has a powerful influence on an economy’s long-term productive capacity. Second, since consumption expenditure accounts for most of the national output, understanding the dynamics of aggregate consumption expenditure is essential to understanding macroeconomic fluctuations and the business cycle. Macroeconomists have studied consumption behavior for many different reasons, using consumption data to measure poverty, examine households’ preparedness for retirement, or test theories of competition in retail industries. A rich variety of household-level data sources (such as the Consumer Expenditure Survey conducted by the U.S. government) allows economists to examine household spending behavior in minute detail and macroeconomists have also utilized these data to examine interactions between consumption and other microeconomic behavior such as job seeking or educational attainment.
Consumption Function
Everybody needs income to purchase goods and services. The higher the level of income, the higher will be the capacity to buy the goods and services. So for an individual, the total amount of goods and services to be purchased depends on the available disposable
income. Similarly, taking all the individuals living in the society or economy as a whole into consideration, it can be said that the aggregate consumption all depends on the total income generated in the economy. When the total income of the economy increases total consumption of the economy will also increase. In the same way, it can also be said that an economy with a higher level of national income consumes more than an economy that has a lower level of national income. Such relationship of income and consumption is explained with the help of consumption function. The consumption function is also known as propensity to consume. The concept of consumption function can be written as under:
C=a+ byd
Where,
C = Consumption Expenditure
a = Autonomous Consumption
b = Marginal Propensity to Consume (MPC) (0<MPC<1)
yd= Disposable Income
Here, autonomous consumption is the level of consumption at zero income level. Autonomous consumption is independent of income. In the above equation, byd is the induced consumption. Thus, total consumption is the sum resulting from the autonomous and induced investment.
Keynesian equation of consumption function
Economist Keynes provided the equation of consumption function. He assumed a short-run period in which the economy is functioning. He argued that the short run is more important because people are more concerned about their immediate consumption needs. He argued that even consumption depends on the level of income, people still manage to consume the necessities needs to sustain themselves, even if there is no income for the time being. For example in a family, children depend on their working parents to consume goods and services. An old person depends on the income of his son or daughter or pension from the government to consume things he needs now. Hence, at any point of time in the short run, there is some fixed amount which the population of the economy spent on consumption even if income is zero or nothing. This part of consumption is called autonomous or fixed consumption. It is a constant and can take any numerical value. Let us denote this value as a. The other part of consumption comes from income and how it increases over time. Once people start getting their income, they use it to repay the loans taken earlier, save for the future and spend a fraction on consumption, over and above the fixed amount of consumption which they had already made earlier. The additional consumption over and above the fixed consumption on necessary things is influenced by the level of income received and MPC of the people. MPC comes into the picture here because it reflects the consumption behavior of the population out of their income. Based on the above arguments as provided by Keynes, we can write the equation of consumption function in the following manner: Consumption = Some fixed amount plus MPC times the current level of income. Symbolically, C = a + MPC × Y where C = Consumption or Y = fixed consumption (Fixed consumption is also called Autonomous consumption i.e. COnsumption at Zero level of Income) Y = Income (disposable Income) MPC = C Y’ ‘.For example, in an economy, the population spends Rs 500 crore on absolute necessities needed to sustain themselves. The current income is Rs 2500 crore and MPC is 0.5, then C = 500 + 0.5 × 2500 = 500 + 1250 = 1750. So consumption is Rs. 1750 crore. If income is zero i.e. Y = 0, Since C = a + b Y Putting Y = 0, it becomes C = a + b x 0 or C = a. So when income is nothing, consumption is equal to the fixed amount which people require to sustain themselves. In the above example, putting Y = 0, We get C = Rs 500 crore.
Propensity to consume
The concept of consumption is incomplete without the study of propensity to consume. The propensity to consume refers to how much consumption an individual or a nation wants to make from the income earned in a particular period or to periods compared. The propensity to consume can be elaborated with the following concepts:
a. Average Propensity to Consume (APC)
APC is defined as the ratio of consumption to income. This ratio is calculated to know the proportion of income devoted for consumption purposes in the specific period of time for which data is given. So APC is calculated for each time period. Let consumption for any particular time is denoted as ‘C’. Let the income of that period be denoted as Y. Then APC = C Y. For example if consumption is Rs 300 Cr. and income is Rs 600 crorethe APC is 300/600= 0.5. This implies that on average 50 percent of the total income has been spent on consumption.
b. Marginal Propensity to Consume (MPC)
MPC is the ratio of change in consumption to change in income between two time periods. Denote “increase in” as “’”, We can write MPC = C Y ‘ ‘. Since consumption depends on income, an increase in income will bring about an increase in consumption over a time period. In this context, MPC measures the increase in the amount of consumption due to an increase in the amount of income in the country. For example, if consumption in period 1 is 200 and income is 300 and the same for period 2 stands at 250 and 400 respectively, the MPC is (250-200)/(400-300)= 0.5. The famous economist, Keynes, who gave the concept of propensity to consume, said that MPC is normally less than unity.
Types of consumption
Consumption refers to the value of goods and services finally consumed by the consumer from her/his income. Consumption has multiple dimensions. Thus, it can be of different types. The different types of consumption are as follows:
- Final consumption: When the consumption is of commodities, consumed directly for the satisfaction of human want, it is known as final consumption or direct consumption. For example, consumption of food articles, stationery, toys etc.
- Productive consumption: When a commodity is used in the production of another commodity, the consumption in this case is known as productive consumption or indirect consumption. For example, the consumption of fatty acids and caustic soda is used in the production of soap production.
- Slow Consumption: Consumption of a commodity that gives satisfaction for a longer period of time is regarded as slow consumption. For example, consumption of consumer durables like air conditioners, television etc.
- Quick Consumption: The consumption of a commodity whose utility is finished the moment it is consumed by the consumer is known as quick consumption. For example, consumption of all single-user goods like a cup of coffee, tea etc.
- Wasteful consumption: Consumption of a commodity whose utility is lost without satisfying any want is called wasteful consumption. For example, mishandling of a new glass container or mirror causes it to break.
What is Saving?
Savings refers to the money that a person has left over after they subtract out their consumer spending from their disposable income over a given time period. Savings, therefore, represents a net surplus of funds for an individual or household after all expenses and obligations have been paid. Savings are kept in the form of cash or cash equivalents (e.g. as bank deposits), which are exposed to no risk of loss but also come with correspondingly minimal returns. Savings can be grown through investing, which requires that the money be put at risk. Saving could be negative as well. Negative savings is indicative of household debt or negative net worth. Savings comprise the amount of money left over after spending. People may save for various life goals or aspirations such as retirement, a child’s college education, the down payment for a home or car, a vacation, or several other examples.
Propensity to save
The saving behavior of people can be studied by calculating their propensity to save in two ways. (i) Average propensity to save (APS) (ii) Marginal propensity to save (MPS). APS: APS is defined as the ratio of saving and income at any point in time. Symbolically APS = S Y. APS gives the idea about the proportion of income devoted towards saving MPS. MPS is defined as the ratio of change in saving and change in income. Over a period of time. MPS is a rate of change in saving vis-a-vis income. Symbolically MPS = S’/ Y’ where S’ = current period saving – last period saving and Y’ = current income – last period income MPS is always less than 1. Example: If income changes from 1000 to 1500 and saving changes from 200 to 250, then if we have to calculate APS and MPS, MPS = (250-200)/(1500-1000)=50/500= 0.1 We can calculate APS for both time period. In the first time period, S = 200 and Y = 1000 So, APS = 200/1000=0.2. In the second time period APS =250/1500= 0.167.
Determinants of savings
Saving is the key element of the total income of an individual or an economy as a whole. The level of saving is dependent on different factors including individual income, need preference and investment prospect. Some of the key determinants of saving have been explained below:
1. The Level of Income:
As Keynes stresses, saving is a function of income. Saving increases with income. Of course, there can hardly be a proportionate relationship between the size of income and savings, but empirical evidence has proved that there is a marked correlation between the two. However, the amount of personal savings depends primarily on disposable income. Thus, the saving income ratio (S/Y) tends to rise with an increase in income. It has been observed that the marginal propensity to save (∆S/∆Y) tends to be high in high-income group sectors of the community.
2. Income Distribution:
Aggregate savings rate also depends upon the distribution of income and wealth in the community. If there is a greater degree of inequality of income among the people, that aggregate savings rate, would tend to be high, as the richer section of the community has a high propensity to save. A country with a low per capita income and a fair distribution of national income would imply a low savings rate. Thus, with an improvement in the distribution of income or correction of income inequalities through fiscal and other measures, the aggregate savings rate may tend to decline in the initial stage.
3. Consumption Motivations:
Saving is the residual part of income left after consumption. Thus, to know the factors affecting saving, we must know what factors determine consumption. The consumption of the community depends upon a variety of factors and motivations.
The pattern of consumption and its volume depends, in general, upon the standard of living of the people. Thus it can be stated that “the level of saving achieved by anyone represents the outcome of the conflict between his desire to improve his current standard of living and his desire to obtain future welfare by saving.”
4. Wealth:
The holding of wealth or liquid assets by a person also affects his consumption decisions. Out of current income, a person would consume more and save less if he possesses an adequate amount of liquid assets like cash balances, bank deposits etc. and feels that his life in the future is well secured. Similarly, an appreciation in the value of financial assets also would induce the person to consume and save less.
5. Habit:
Habit is a major determinant of consumption patterns. As a matter of fact, at any one moment, a consumer already has a well-established set of consumption habits. The habit of consumption is formed by taste, likings, fashion and other psychological influences on the minds of consumers.
6. Population:
The high growth of the population has an adverse effect on the per capita income which causes an adverse effect on the saving-income ratio. Again, the age distribution of the population also affects the volume of aggregate savings in the economy. Aggregate personal saving depends upon the dissaving of old, retired people and the saving of the younger group. A community’s aggregate saving would be zero when the positive saving of the young people is just balanced off by the dissaving of the retired people to maintain their consumption expenses.
7. Objective and Institutional Factors:
There are a number of objective factors — mostly institutional by nature —which affect the capacity and willingness to save the people at large. Political stability and security of life and property encourage people to save more. Similarly, the existence of a good banking system and other developed financial institutions of money and capital market such as Unit Trust, Life Insurance Corporation, financial houses, shares of good corporations, government bonds and securities etc. induce people to save more under the economics of interest-earning motive by providing a wide range of remunerative investment opportunities.
The taxation structure and fiscal policy also affect savings in the economy. A vigorously progressive direct taxation leads to a reduction in voluntary personal savings. Similarly, high and widespread indirect taxes will force the consumer to spend more on maintaining his given standard of living. This will cause a reduction in his saving. On the other hand, certain concessions provided in the taxation schemes can help in promoting voluntary saving.
8. Subjective Motivations for Savings:
People are induced to save more when there are strong subjective factors that motivate them to save. Keynes enlisted the following main motives which lead to individuals to save:
1. Precaution — to build up a reserve against unforeseen contingencies.
2. Foresight — to provide for future needs.
3. Calculation — to enjoy interest and a larger real consumption at a future date.
4. Improvement — to improve the standard of living gradually.
5. Independence — to enjoy a sense of independence and the power to do things with accumulated savings.
6. Enterprise — to make speculation or undertake business projects.
7. Pride — to bequeath a fortune.
8. Avarice — to satisfy pure miserliness.
Likewise, savings of business firms are induced by the following motives:
(i) Enterprise — to carry out further capital investment.
(ii) Liquidity — to meet emergencies of business.
(iii) Improvement — to expand business investments.
(iv) Prudence — to have financial prudence in discharging debts.
9. Rate of Interest:
According to classical economists, saving is the direct function of the rate of interest.
To put it symbolically:
S = f (i)
Where S stands for saving and I stands for the rate of interest. It suggests that saving tends to rise with an increase in the rate of interest and vice versa. Keynes, however, did not agree with this view. He asserted that saving is a function of income. But, it remains a fact that the personal saving of some individuals who are motivated by economic considerations is certainly induced to save more when the rate of interest rises. They may be willing to curtail their consumption or try to earn more income to save more. But, a mere rise in the rate of interest is not enough. Income also must rise.
However, the rate of interest is an important factor in the mobilization of savings. People would be induced to pass on their savings to those institutions which offer a high rate of interest. Thus, from the point of view of holding of near money assets, the rate of interest constitutes a significant influence. A person would like to keep his savings in that type of bond from which the relative yields will be highest as against any other type available.
